Any hope of a pause in monetary tightening by the U.S. Federal Reserve faded during the third quarter of 2022. Stocks and bonds tumbled toward the end of the quarter when the Fed Chairman vowed to fight inflation, even at the expense of economic growth.
Consequently, the yield on the ten-year U.S. Treasury note climbed above 4% for the first time in more than a decade, while the dollar strengthened against other currencies to a decade high. The persistence of inflation and the moves by central banks around the world to raise rates have slammed markets. Meanwhile, Russia’s war in Ukraine and China’s continuing COVID lockdowns have further weakened the global economy.
It takes time for the full effects of higher interest rates to filter through the economy, leaving investors wondering how the sequence of rate increases will eventually affect the behaviour of businesses and consumers. Given the pace of monetary tightening, many suspect that an economic slowdown will dent corporate earnings and erode the attractiveness of company bonds and shares.
Debt markets are under stress. An investment strategy used by UK pension funds to protect themselves from falling yields in the government bond market has been blamed for backfiring when they surged instead. Funds following Liability Driven Investment strategies were forced to post more collateral on their derivative positions when prices for UK sovereign gilts collapsed suddenly, driven largely by their own selling.
That prompted the Bank of England to step in to prevent a death spiral and a systemic crash. Wild swings were also felt in the bond markets after a UK government tax cut plan.
Corporate Bond Fund
As Canadian yields rose sharply in the short end, the Pembroke Corporate Bond Fund returned 0.27% in the last quarter, narrowly outperforming the benchmark by three base points. Despite being significantly overweight short-term bonds, the Fund was able to outperform due to security selection and a large weight in floating rate notes. Bonds issued by Bombardier, Spirit Aerosystems and American Airlines lead performance for the period.
The Fund continues to increase credit quality and to maintain a duration meaningfully below that of the index to mitigate the negative impact of rising interest rates. The Fund is well positioned with a yield of 6.6%, a duration of 2.2 years, and approximately 32% in floating rate notes. As elevated inflation persists and central banks play catch-up, yields are expected to continue to converge to inflation. The Fund will maintain its defensive positioning and increased weight in high-quality liquid bonds, which can be used to take advantage of future opportunities.
Canadian Bond Fund
The Pembroke Canadian Bond Fund returned 0.18% during the third quarter, underperforming the benchmark by 0.34%, as Canadian yields rose sharply in the short end, and lower quality credit outperformed. Despite having a shorter than benchmark duration, the Fund achieved positive returns through its defensive positioning, as notable weights in government bonds were positive for the period.
The Fund ended the quarter with a yield of 4.7% and a duration of 5.2 years, which compares favourably with the benchmark yield of 4.1% and duration of 7.5 years. As elevated inflation persists and central banks play catch-up, yields are expected to continue to converge to inflation. The Fund will maintain its defensive positioning and increased weight in high-quality liquid bonds, which can be used to take advantage of future opportunities.
Other Articles Of Interest
This report is for the purpose of providing some insight into Pembroke and the Pembroke funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.